By François Degeorge, Swiss Finance Institute at the University of Lugano (USI),
Jens Martin, University of Amsterdam,
Ludovic Phalippou, Saïd Business School, University of Oxford
In recent years 40 percent of private equity (PE) exits have taken the form of secondary buyouts (SBOs), transactions in which a private equity firm sells a portfolio company to anher private equity firm. By contrast, 20 years ago private equity firms seeking to exit either took their portfolio companies public or sold them to another company active in the same industry. PE investors (the limited partners with stakes in PE funds) have watched the rise of SBOs with concern: Does the rise of SBOs help or hurt PE investor returns?
The first concern investors have is that SBOs are “pass-the-parcel” deals in which the buying PE fund mainly seeks to spend capital and collect fees. PE funds are usually structured as 10-year limited partnerships. The fund’s general partner has up to five years to invest the capital committed by the limited partners. Once this investment period expires, the general partner typically earns management fees on only the invested portion of the fund’s capital. Moreover, raising a new fund is harder if an existing fund has a lot of unspent capital (known as “dry powder”). This PE fund timeline creates an incentive for a general partner to burn money at the end of the investment period.
SBOs are a prime investment target for a general partner with dry powder. Potential SBO targets are easy to identify. Their owners are other PE funds, eager to divest before the end of their own fund’s life. As expressed by The Wall Street Journal’s “Heard on the Street” column, “unused capital, known as ‘dry powder,’ […] could give some managers an incentive to scramble and spend money before it expires. And it may already be visible in secondary buyouts”.
Our analysis of a large dataset of SBOs confirms that general partners tend to burn money when they invest in SBOs near the end of the investment period. Net of fees, these late SBOs return USD 0.88 on average when an investment in the stock market index would have returned USD 1. SBOs bought late in the investment period also tend to be slightly riskier than other buyouts.
The funds that burn money by buying SBOs late in their investment period appear to be penalized by investors, who “vote with their feet” and participate less in the next fund raised by the same private equity firm. SBOs that take place early in the investment period (roughly two-thirds of SBOs) perform as well as other buyout transactions and generate a positive net present value for investors, similar to other buyout transactions.
A second often expressed concern about SBOs is what additional value, if any, the buyer can bring to the portfolio company compared to that offered by the first private equity owner. As expressed in The Economist, “once a business has been spruced up by one owner, there should be less value to be created by the next”.
We uncover an important source of value creation in SBOs: the presence of complementary skillsets between the buyer and the seller. By examining the education and career paths of the general partners of PE funds, and the geographical presence and strategies of PE firms, we classify these firms as finance-oriented or operations-oriented; MBA-dominated or not MBA-dominated; regional or global; and “margin grower” or “sales grower”. We find that more value gets created (and buyers capture a greater share of this value) in SBO transactions between firms with complementary skills than in SBOs between firms with similar skills. The net-of-fees net present values of SBOs that occurred between two complementary PE firms are large and positive. In contrast, and consistent with investors’ concerns about SBOs, transactions between funds with no complementary skills do not generate value for investors.
The third source of investors’ concerns about SBOs is the situation known as “limited partner overlap”. Limited partners are often invested in several private equity funds. As a result, they can find themselves on both the buying and the selling side of an SBO transaction. Consequently, investors end up owning the same asset after the SBO, but they have paid large transaction costs. As noted in The Economist, “investors who back private-equity firms […] are less than happy with the rise of secondaries. [T]hey are in essence buying firms from themselves, with hefty transaction costs.”
We argue that contrary to the widespread view, limited partner overlap does not lead to extra transaction costs in SBOs, at least if one recognizes two fundamental features of PE funds: PE funds have a finite life, so that all investments need to be exited sooner or later; and general partners always invest the capital committed by investors. As a result, for every dollar committed to a fund, investors pay two rounds of transaction costs: one when the dollar is invested by the general partner and another when it is divested. This accounting identity holds regardless of the transactions undertaken by the general partner (initial public offering, sale to a strategic buyer, or SBOs with or without limited partner overlap).
If limited partners do not pay extra transaction costs in SBOs with limited partner overlap, why do they resent them? Probably because of two peculiarities of such transactions: investors pay the entry and exit transaction costs simultaneously, and they still indirectly own the same asset after the transaction. These two peculiarities expose the reluctance of general partners to return unspent capital to investors, and their preference for burning money instead.
We estimate that investors with stakes in more than 20 PE funds face a one-in-six chance of finding themselves on the buying side of an SBO transaction if they are already on the selling side. The eventuality of limited partner overlap in SBOs actually gives investors an opportunity to optimize their capital allocation across PE funds: investors can stack the deck in their favor by investing in funds with complementary skills, which, as we have shown, generate more value.
Overall, PE investors’ concerns about SBOs are only partially warranted. SBOs that take place under the pressure to burn money destroy value for investors; others do not. SBOs between PE funds with complementary skills generate value for investors; others do not. SBOs with limited partner overlap do not generate extra transaction costs for investors, but only under the assumption that each dollar committed will be spent—an assumption that, while true in practice, is unlikely to be value-maximizing for PE investors.
The Wall Street Journal, September 26, 2012, p. 32.
“Circular logic”, The Economist, February 10, 2010.
“Buy-in barons”, The Economist, January 18, 2014.
The complete academic study on which this article is based has been published in the Journal of Financial Economics and is available free of charge at http://bit.ly/1Nx88mP.